Investing in publicly-traded, early-stage, microcap biotech stocks can be very profitable. For example, if you had invested in shares of Advaxis (ADXS) in 2014 which traded at less than $4 for most of the year, you could have made at least a 75% return, as shares are now higher than $7 (at the time of this writing). However, investors can often get enamored with a technology and sometimes overlook the financial risks associated with early-stage biotechnology companies.
Since most early-stage biotechs do not generate revenue, they often have to raise capital to fund development of their pipeline products. Publicly-traded companies usually raise capital from institutional investors (i.e. hedge funds or mutual funds) in follow-on offerings. To entice institutional investors, companies will sometimes offer shares at a discount to the open market price and warrants in return for capital. When companies issue new shares to raise money, the current shareholders get diluted, and share prices typically drop.
Depending on the discount and warrants offered, there can be a near-term overhang that prevents price appreciation even after an offering is completed. While some new investors may be long-term shareholders, others will start selling shares right away, which keeps a downward pressure on the share price. For example, let’s say a stock is trading at $1.50/share and an investor receives one million shares at $1.00 and 50% warrant coverage at an exercise price of $1.00. The investor can then sell all of their shares at $1.00/share or more to get their principal back and keep the warrants (which were free) to enjoy any future increase in share price.
Before investing in early-stage biotechs, remember to take a look at the balance sheet to see how much cash is left. Management will want to have at least enough cash to last a year. A company’s past expenses will give you an idea of the burn rate, but also consider the cost of clinical trials that have yet to be initiated. Management will typically raise capital after positive news and stock price appreciation. Also, keep in mind that sell-side analysts do not always mention financing risks, because they want their investment bankers to raise capital for the company; so be wary of buy recommendations.
In a future post, I will give you an real-life example of what happens when a microcap biotech company raises money.